Smoothing the shocks of a dynamic stochastic general equilibrium model

Bauer, Andrew; Haltom, Nicholas; Rubio-Ramirez, Juan F.

Journal Article

Smoothing the shocks of a dynamic stochastic general equilibrium model

Abstract: In some ways, the recession of 2001 and the recovery that followed it were unique: During the recession, the contraction in measured output was driven almost entirely by a retrenchment in business capital spending while consumer spending and residential investment remained positive. And the recovery was marked by moderate, uneven gross domestic product growth and job market weakness that were historically unusual. These events raise questions about the conventional wisdom on post?World War II business cycles. ; To help answer these questions, the authors use a general equilibrium model with sticky prices and sticky wages as a framework for exploring the effects of structural shocks to the U.S. economy. Using the Kalman filter, the authors estimate the parameters of the model and then back out the unobservable shocks that make the model?s observed variables match the observable data. ; The model shows that during the 1990?91 and 2001 recessions demand shocks turned sharply negative as output growth weakened. However, the model attributes the relatively small decline in output during the 2001 recession to a positive productivity shock. Both the 1990?91 and 2001 recessions exhibited a sudden loosening of monetary policy greater than would be predicted by a Taylor rule. The model does not capture inflation dynamics during these periods and attributes frequent changes in inflation to the markup shock.

Keywords: Business cycles; Econometric models;